IB Econ Study Guide Internationals - Sunny Hills High School

Why do exchange rates
Factors that may affect trade flows: changes in relative
inflation rates
. lf inflation in a country accelerates it means that prices in
that country are rising on average fasler than they dld. As
a result its products will become less and less competitive
aDroao.
. lts exports will decrease and so will the demand for its
currency in foreign exchange markets. ln addition, foreign
products (imports) will now seem relatively more attractive
to domestic househo ds. lmport spending will tend to rise
and thus supply of iG currency in foreign exchange markets
(as they will need more dollars to pay for these imports).
. Figure 4.12 illustrates the effect of higher inflation in
lndonesia on its currency, the rupiah. Initially the rupiah is
valued against the dollar at e7.
. The higher inflation in Indonesia will have an adverse
effect on its exports as they will become less competitive
abroad and thus decrease. decreasing the demand for the
rupiah from D1 to D2.
. At the same time inflation will make Indonesians find
foreign products more and more attradive. lmporls will
tend to increase and thus more rupiahs wlll be supplied in
the foreign exchange market, shifting the supply of rupiahs
from 51 to 52. The rupiah wlll tend to depreciate to e2.
. Inflatlon in an economy will tend to depreciate a currency.
Figure 4.12 Effect of higher inflation on the exchange rate
-E FE
may be constrained. Many economies limit the types of
foreign investment flows they permit as some of these
investments may prove very destabilizing. Short-term
speculative capital may suddenly be withdrawn leading to
a sudden sharp depreciation and consequently to adverse
real effects on the economy. There rs a lot of discussion
on the desirability of such private capital inflows especially
for developing countries.
Factors that may affect investment tlows: changes in relative
interest lates
. lf interest rates in a country decrease then domestic bonds
as well as savings deposits in the domestic currency will
be less attractive to foreign investors as they will earn less
on their financial investments.
. As a result not only will demand for that currency decrease
as there will be less demand for that country's bonds, but
also there will be an increase in the supply of that countryS
currency as investors will sell that currency to buy currency
and bonds of other countries. The effect of lower interest
rates will be a tendenry for the currency to depreciate.
. In Fig. 4.13 we assume that the dollar price of the euro
is inilially at e 7. Let the European Central Bank decrease
interest rates. Now the rate of return on European bonds
as well as on deposits in euros is lower so these assets will
be less attractive to investors.
. Demand for the euro will decrease from D1 to D2 reflecting
the lower demand for European bonds and euro deposits.
. Also, some holders of such assets will decide to sell them,
: .6
E99'
!4E"'
51 of
(M1)
Rupiah
(M2 > M1)
increasing the supply of euros from s1 to s2 as they will
switch to more attract ve bonds issued by other countries.
The euro will tend to depreciate from e/ to e2.
. A note of caution here: if interest rates rise there will be
a tendency for the exchange rate to appreciate, assum,hg
that foreign inveslors do not exoect the cLrrency to
depreciate. For example if interest rates in country A
rise then investors will not flock into that country if they
expect its currency to depreciate. 50 interest rates do
matter but so does the expectation about the future path
of the exchange rate itself.
(x2 <
Rupiah traded Per Period
Factors that may affect investment (capital) flows
. lnvestment flows are also referred to as capital flows and
lnclude porffolio investments (the buying and selling of
bonds, stocks and other financial assets) and FDI (foreign
direct jnvestment which refers to investors establishing a
presence in a foreign country eilher by setting up a new
firm or by acqulring a controlling share of an existing
domestic firm).
. l\y'uch of these capital flows are shorl term and specuiative
in nature. Currency speculation is also included in this
section. These transactions are included ln the capital
account of the balance of payments of a country
. Bear in mind that not all countries have fully liberalized
their capital account. Thrs means that foreign investment
Figure 4.13 Effect of lower interest rates on the exchange rate
EE
E
g
Sl for euros
52 for euros
in EUl s)
D1 for euros
in EU15)
D2 Jor euros
(when r = 12 < rl in EU15)